The Billabong bounce

A recent takeover bid for Billabong highlights the winners and losers in derivative trading. In this case short sellers were caught out.

PORTFOLIO POINT: The strong band of short sellers were caught out when a takeover bid triggered a sharp rise in Billabong’s share price.

Short selling is frequently criticised and hedge funds who short sell are often (unfairly in my view) vilified as vultures. However, short selling provides the market with liquidity as well as allowing option traders to hedge their exposure. Overall, short selling helps to create an “efficient market”.

However, short selling doesn’t come without significant risk. The best example is that an unloved and underperforming company is subject to a takeover at a significant premium to the current market price. Take for example two recent and current examples, Billabong and TNT Express.

First, however let’s examine the concept and the mechanics of short selling. Most investors understand that they need to follow the rule of “buying low, selling high” with the profit being the difference. Short selling does exactly the same, but in the reverse order – “selling high, buying low”. Again, the profit remains the difference.

There are operational and regulatory restrictions on short selling, based around being able to deliver stock (shares in the case of equities) to the buyer. ASIC regulations don’t allow “naked” short selling, so the short seller needs to borrow stock to initially deliver, and then to return the stock (or equivalent) once the trade is bought back to complete the process.

In practice, the short seller (normally a hedge fund) needs an efficient and ready source of stock to borrow. This is achieved through the services of a “Prime Broker” and large institutional shareholders, who lend the necessary stock in return for a fee as a way of improving their overall investment returns.

Option market makers may also sell short is to hedge their potential “long” exposure created when selling put options. More of this at another time!

There may be multiple reasons for investors to believe a company’s shares are overpriced: The sector might be experiencing a downturn (eg, retailing in a recession, or mining when commodity prices are falling); the industry might have fundamental structural or technology issues (car manufacturers); poor company management, or be subject to internal dissent or even fraud, or it may simply be that they are not performing as well as their competitors.

In this environment a long-only investor either sells or reduces their investment, or hopes (which is not generally considered to be a good investment strategy) that gravity will not prevail.

Meanwhile, the short seller confirms with their Prime Broker that they can borrow stock, sells short (reporting the sale to ASIC, as required to keep the market informed) and waits for the share price to fall to fair value, whereupon they repurchase and return the borrowed stock.

If the short seller is wrong and the stock doesn’t fall, or rises, their internal “stop loss” risk limits will kick in (most funds have well documented and strict limits, particularly on short positions) and not too much damage is caused. Strangely enough, the issue can arise when they get the investment thesis right '¦ or the timing wrong, usually in the case of takeovers.

Takeovers frequently occur when a company is underperforming even though it has fundamentally sound assets or brands. Competitors or private equity see an opportunity and seek to realise the latent value, but to do so have to bid well above the market price to dislodge long-term shareholders, and often long term management and directors. So to our two recent and current examples.

Billabong, the iconic Australian surfwear manufacturer fell from $9 to below $1.70 in the past 12 months as the market sold it off on the poor outlook for discretionary retail sales at home and abroad, coupled with high and unsustainable debt levels. On Wednesday, with over 10% of its shares registered with ASIC as “short”, Billabong was trading at $1.63 before going into a trading halt as news of a $3 bid reached the market. On Friday after trading resumed the price jumped over 50% to a high of $2.93 before closing up 46% at $2.62.

TNT Express: With US and European economies close to – or already in – recession, and concerns over operational issues, the 52-week US share price of the Dutch-owned transport group TNT USA had fallen from over $US14 to $US6.10. On Friday, the stock was trading at $US8.27 when an offer from rival transport operator UPS was revealed, which saw the price jump to $US12.57 for a gain of 55% on the day.

Back to the hedge fund manager’s internal “Stop Loss” limits. Frequently set at between 5% and 10% on any individual position, when the price moves to this level a stop loss is triggered requiring the position to be bought back. In a takeover situation a “short squeeze” is frequently created pushing the price up further as sellers pull back in hope of further price rises. Adding to the risk is that while a stop loss risk limit may be triggered when the price gains 10%, there’s no guarantee that the order can be executed at that level – as in the above example of Billabong where the price gapped up 50% before trading.

As hedge fund managers generally report their performance based on market positions at the end of each month, realised or not, a 50% loss on a single position, and often in a concentrated portfolio, is significant.

Although in practice highly unlikely, theoretically the loss on a short position is unlimited. However, managers who ignore risk limits can find themselves facing even higher losses, and history is littered with those who didn’t hold to the old rule of “take your losses early, let your profits run”.

For those with no sympathy for the hedge fund manager losing on a short position, bear in mind that they’re investing on behalf of their investors, who profit or lose based on the manager’s skill and market expertise.

And remember that for every loser there’s normally a winner as shown in the above example of TNT. A hedge fund manager, Jana Partners, bought the stock as it sought two seats on the board and to force operational improvements or to prod TNT into a sale. They will no doubt be happy with any short squeeze pushing the price further.

Chris Gosselin is chief executive of Australian Fund Monitors, a hedge fund information consultancy.

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